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    Geographic Proximity between Auditor and Client: How Does It...
    research summary posted October 16, 2015 by Jennifer M Mueller-Phillips, tagged 11.0 Audit Quality and Quality Control 
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    Title:
    Geographic Proximity between Auditor and Client: How Does It Impact Audit Quality?
    Practical Implications:

    The results help the authors better understand why local audits are so prevalent, and Big 4 audit firms have continuously expanded their practicing offices to cities in which their clients are headquartered. The results of this study suggest that decentralized local office structures reduce information asymmetries between clients and auditors, thereby allowing office-level auditors to improve client-specific knowledge. Furthermore, this study will be of interest to regulators, since it demonstrates that the proximity of auditors to clients can be beneficial to audit quality.

    Citation:

    Choi, J., J. Kim, A. A. Qiu, and Y. Zang. 2012. Geographic Proximity between Auditor and Client: How Does It Impact Audit Quality? Auditing: A Journal of Practice & Theory 31 (2): 43-72.

    Keywords:
    audit quality, auditor locality, diversification, geographic proximity
    Purpose of the Study:

    Since the Enron debacle and the subsequent collapse of Arthur Andersen, regulators, lawmakers, academic researchers, and the popular press have paid considerable attention to engagement-specific factors determining the auditor-client relationship and their impact on audit quality. The focus of this study is on a new engagement-specific factor that may play an important role in the development of the auditor-client relationship: geographic proximity between auditor and client, or auditor locality. Specifically, the authors examine whether the geographic distance between auditor and client plays a role in determining audit quality.

    This study is motivated by a growing body of literature in accounting and finance that documents the importance of geographic proximity between economic agents. This strand of research suggests that geographic proximity lowers the information asymmetry between economic agents by facilitating information flows and monitoring. Building upon the implication from this recent literature, the authors expect that local auditors possess an informational advantage over non-local auditors because proximity to clients can facilitate the acquisition of more idiosyncratic client information, such as client-specific incentives, means, and opportunities for substandard reporting. They posit that this informational advantage attenuates managerial opportunism in financial reporting, because greater client-specific knowledge enables auditors to better identify and rein in aggressive reporting practices. They expect, however, that this effect of auditor locality is weakened for diversified clients with more operating divisions or geographic segments, because the audit advantage associated with geographic proximity to client headquarters is likely to be smaller for such clients.

    Design/Method/ Approach:

    The final sample consists of 12,439 firm-year observations located in 192 MSAs included in the Audit Analytics database and the U.S. Census Bureau’s 2000 Places file for the four-year period 20022005. The authors also obtain nonaudit fees data from the Audit Analytics database. They retrieve all other financial data from the Compustat Industrial annual file. The observations are audited by auditors from 767 unique audit practice offices located in 110 MSAs.

    Findings:
    • First, after controlling for a comprehensive set of variables known to affect the extent of opportunistic earnings management, the authors find that the clients of local auditors report a lower level of absolute discretionary accruals and a higher level of accrual quality compared to those of non-local auditors.
    • Second, the authors find that these associations are relatively weaker or absent for diversified clients with more operating and/or geographic segments. This evidence is consistent with the view that local audit advantages are greater when information transfers between a firm and its stakeholders, including auditors, occur mostly at the corporate headquarter level, and auditors perform their audit work primarily at headquarters. For more diversified firms, a larger part of business operations is performed in multiple locations, other than where the firms are headquartered. As a result, an auditor’s informational advantage associated with geographic proximity to headquarters is likely to diminish.
    Category:
    Audit Quality & Quality Control